In an exclusive interview, Amanda White, editor of top1000funds.com, talks to the modern portfolio theorist about markets, portfolio rebalancing, Madoff and more.
Despite the hype by some commentators that today’s market constitutes a ‘Black Swan’, the fall in equities markets experienced in the past year is only a two standard deviation event, and well within normal expectations, according to Harry Markowitz.
When asked to discuss the latest market disruption, he is quick to make a distinction between portfolio theory and financial engineering.
“Portfolio theory is top down asset allocation with money allocated to professional funds managers; while financial engineering is structured products, which has led to a lot of highly leveraged products,” he says. “The S&P500 went down 28 per cent in 2008, which is between a 2 and 2.5 standard deviation event and completely within the normal distribution, it is not a Black Swan, which is about eight standard deviations.”
The current government intervention in markets and companies is a sore point, and he calls the bailout by the US government “silly”, believing instead that markets should be left to their own devices.
[As an aside he points to an article he co-wrote with Nilufer Usmen in the Journal of Risk and Uncertainty, on the likelihood of various stock market return distributions, which he says “found that Black Swans do happen daily, but not often to markets”Â.]
According to Markowitz this financial crisis is the result of two major forces.
“Back in 1999 Congress passed laws and put pressure on Fannie Mae to accommodate low-cost housing, they basically mandated the sub prime mortgages. This combined with financial engineering – CMOs, CDOs etcÂ – contributed to the financial crisis. Modern Portfolio Theory completely holds up, he says, warning institutions not to get too smart, and instead to concentrate on asset allocation.
Markowitz supports the asset allocation of the larger endowments, and more pertinently their commitment to decision-making. He even names David Swensen, chief investment officer of Yale endowment, as his idol (he was meeting him for the first time late last month).
However he says not everyone can emulate that model.
“Swensen says you have to have 25 to 30 professionals looking into private placements, if you don’t have the time and skill to do that then stay away from it,” he says. “Nothing is for sure in this world.”
Being a mathematician, Markowitz is an advocate of ETFs, and while initially stating he is agnostic about active funds management, he soon reneges on that comment.
“I ran an arbitrage fund for about three years in the 1970s before everyone was doing it, and there are times that certain arbitrages work,” he says.
But with the trend towards concentrated portfolios offered by funds managers, he says “if your whole portfolio is concentrated then that is dangerous…Fischer Black and Jack Treynor introduced the idea of active/passive. A manager may say they have 10 great ideas a year, but that is not enough to give you a diversified portfolio; so have the diversified portfolio and the good ideas. It is reasonable to do that, but don’t trust anyone’s judgement completely. I can’t understand a wealthy person giving all their money to Madoff.”Â
It is hard to imagine there was ever an investing world without the theory of diversification, first introduced by Markowitz in the 1950s, but the magnitude of meeting the man behind the revolutionary idea is lost as soon as you meet him. A most welcoming and sincere man, age has not slowed Harry Markowitz whose ideas just keep coming.
Currently he and his old friend and contemporary, Bill Sharpe (he of the ratio), are working on a number of projects and in addition to his private advisory work, Markowitz still teaches at the University of San Diego for two semesters a year.
But the biggest test of his longevity is the application of his newer academic ideas into practice.
A paper by Markowitz and Erik van Dijk, “Single-period mean-variance analysis in a changing world”, first appeared in the Financial Analysts Journal as recently as 2003 and has been used by State Street in portfolio rebalancing.
“Erik and I looked at: how do you approximately optimise when you have illiquidities and changing probability distributions. We call State Street’s application the “sliced bread” as in the best thing since sliced bread,” the Nobel laureate says.
In the Journal of Investment Management, the theory was put to the test by Mark Kritzmanfrom MIT’s Sloan School of Management, Simon Myrgrenand Sebastien Pagefrom State Street Associates. They examined the academics’ theory in a paper titled “Portfolio Rebalancing: A Test of the Markowitz-Van Dijk Heuristic”.
In this paper they summarise as follows: Institutional investors usually employ mean-variance analysis to determine optimal portfolio weights. Almost immediately upon implementation, however, the portfolio’s weights become sub-optimal as changes in asset prices cause the portfolio to drift away from the optimal targets. In an idealised world without transaction costs investors would rebalance continually to the optimal weights.
In the presence of transaction costs investors must balance the cost of sub-optimality with the cost of restoring the optimal weights. We apply a quadratic heuristic to address the asset weight drift problem, and we compare it to a dynamic programing solution as well as to standard industry heuristics.
Our tests reveal that the quadratic heuristic provides solutions that are remarkably close to the dynamic programing solutions for those cases in which dynamic programing is feasible and far superior to solutions based on standard industry heuristics.
In the case of five assets, in fact, it performs better than dynamic programing due to approximations required to implement the dynamic programing algorithm. Moreover, unlike the dynamic programing solution, the quadratic heuristic is scalable to as many as several hundreds assets.
For Markowitz, who has done a series of research in the past five years, he points to this work as the most satisfying.
“I’m most pleased with my work with van Dijk on the single-period mean-variance analysis because that was what was plaguing me the most,” Markowitz says.
At the age of 82 he often ponders “where ideas come from” and recently at a dinner with friend Jack Trayner, the pair deliberated why they were “different”, but overall he says the ideas come from stimulation.
His unimposing office in a low rise in San Diego is lined with hundreds of books and he constantly reads papers and research.
“I don’t know where the ideas come from, but I am happy with them. What would I do if I didn’t do this? The main challenge is writing, it is a matter of organising my time. The ideas keep coming, they keep coming from stimulation,” Markowitz, who says his chief competition “is me when I was 25”, says.